Chapter - 2

Concepts of Value
and Return

Chapter Objectives
Understand what gives money its time value.
Explain the methods of calculating present

and future values.

Highlight the use of present value technique
(discounting) in financial decisions.
Introduce the concept of internal rate of
return.

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Time Preference for Money

Time preference for money is an individuals

preference for possession of a given amount

of money now, rather than the same amount
at some future time.
Three reasons may be attributed to the
individuals time preference for money:

risk
preference for consumption
investment opportunities

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Required Rate of Return

The time preference for money is generally

expressed by an interest rate. This rate will be

positive even in the absence of any risk. It may
be therefore called the risk-free rate.
An investor requires compensation for assuming
risk, which is called risk premium.
The investors required rate of return is:
Risk-free rate + Risk premium.

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Time Value Adjustment

Two most common methods of adjusting cash

flows for time value of money:

Compoundingthe process of calculating future

values of cash flows and
Discountingthe process of calculating present
values of cash flows.

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Future Value
Compounding is the process of finding the future

values of cash flows by applying the concept of

compound interest.
Compound interest is the interest that is received on
the original amount (principal) as well as on any
interest earned but not withdrawn during earlier
periods.
Simple interest is the interest that is calculated only
on the original amount (principal), and thus, no
compounding of interest takes place.

Financial Management, Ninth Edition I M Pandey

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Future Value
The general form of equation for calculating

the future value of a lump sum after n periods

may, therefore, be written as follows:

Fn P (1 i ) n
The term (1 + i)n is the compound value

factor (CVF) of a lump sum of Re 1, and it

always has a value greater than 1 for positive
i, indicating that CVF increases as i and n
increase.

Fn =P CVFn,i

Financial Management, Ninth Edition I M Pandey

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Example
If you deposited Rs 55,650 in a bank, which

was paying a 15 per cent rate of interest on a

ten-year time deposit, how much would the
deposit grow at the end of ten years?

We will first find out the compound value

factor at 15 per cent for 10 years which is

4.046. Multiplying 4.046 by Rs 55,650, we get
Rs 225,159.90 as the compound value:
FV 55,650 CVF10, 0.12 55,650 4.046 Rs 225,159.90

Financial Management, Ninth Edition I M Pandey

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Future Value of an Annuity

Annuity is a fixed payment (or receipt) each

year for a specified number of years. If you rent

a flat and promise to make a series of
payments over an agreed period, you have
created an annuity.
(1 i ) n 1
Fn A

The term within brackets is the compound

value factor for an annuity of Re 1, which we

shall refer as CVFA.
Fn =A CVFA n, i
Financial Management, Ninth Edition I M Pandey
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Example
Suppose that a firm deposits Rs 5,000 at the

end of each year for four years at 6 per cent

rate of interest. How much would this annuity
accumulate at the end of the fourth year? We
first find CVFA which is 4.3746. If we multiply
4.375 by Rs 5,000, we obtain a compound
value of Rs 21,875:
F4 5,000(CVFA 4, 0.06 ) 5,000 4.3746 Rs 21,873

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Sinking Fund
Sinking fund is a fund, which is created out of

fixed payments each period to accumulate to a

future sum after a specified period. For
example, companies generally create sinking
funds to retire bonds (debentures) on maturity.
The factor used to calculate the annuity for a
given future sum is called the sinking fund
factor (SFF).

i
A = Fn
n

(1

i
)

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Present Value
Present value of a future cash flow (inflow or

outflow) is the amount of current cash that is

of equivalent value to the decision-maker.
Discounting is the process of determining
present value of a series of future cash flows.
The interest rate used for discounting cash
flows is also called the discount rate.
Present value can be converted to Future
n

value by multiplying PV with (1+ i)

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Present Value of a Single Cash Flow

The following general formula can be employed to

calculate the present value of a lump sum to be

received after some future periods:
Fn
n

F
(1

i
)
n
n
(1 i )
The term in parentheses is the discount factor or

present value factor (PVF), and it is always less

than 1.0 for positive i, indicating that a future amount
has a smaller present value.
PV Fn PVFn ,i
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Example
Suppose that an investor wants to find out

the present value of Rs 50,000 to be

received after 15 years. Her interest rate is
9 per cent. First, we will find out the present
value factor, which is 0.275. Multiplying
0.275 by Rs 50,000, we obtain Rs 13,750 as
the present value:
PV = 50,000 PVF15, 0.09 = 50,000 0.275 = Rs 13,750

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Present Value of an Annuity

The computation of the present value of an

annuity can be written in the following general

form:
1
1
P A

n
i i 1 i

The term within parentheses is the present

value factor of an annuity of Re 1, which we

would call PVFA, and it is a sum of singlepayment present value factors.
P = A PVAFn, i
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Capital Recovery and Loan

Amortisation

Capital recovery is the annuity of an investment

made today for a specified period of time at a

given rate of interest. Capital recovery factor
helps in the preparation of a loan amortisation
(loan repayment) schedule.

1
A= P

PVAF
n ,i

A = P CRFn,i

The reciprocal of the present value annuity factor

is called the capital recovery factor (CRF).
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Present Value of an Uneven

Periodic
Sum

Investments made by of a firm do not

frequently yield constant periodic cash flows
(annuity). In most instances the firm receives
a stream of uneven cash flows. Thus the
present value factors for an annuity cannot be
used. The procedure is to calculate the
present value of each cash flow and
aggregate all present values.

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Present Value of Perpetuity

Perpetuity is an annuity that occurs

indefinitely. Perpetuities are not very common

in financial decision-making:
Present value of a perpetuity

Perpetuity
Interest rate

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Present Value of Growing Annuities

The present value of a constantly growing

annuity is given below:

A
1 g
P=
1

i g
1 i

Present value of a constantly growing

perpetuity is given by a simple formula as

follows:
P=

A
ig
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Value of an Annuity Due

Annuity due is a series of fixed receipts or

payments starting at the beginning of each

period for a specified number of periods.
Future Value of an Annuity Due
Fn = A CVFA n , i (1 i)

Present Value of an Annuity Due

P = A PVFA n, i (1 + i )

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Multi-Period Compounding
If compounding is done more than once a

year, the actual annualised rate of interest

would be higher than the nominal interest rate
and it is called the effective interest rate.

EIR =

i
1
m

n m

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Continuous Compounding
The continuous compounding function takes

the form of the following formula:

Fn P ei n P e x

Present value under continuous compounding:

Fn
P i n Fn e i n
e

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Net Present Value

Net present value (NPV) of a financial

decision is the difference between the

present value of cash inflows and the present
value of cash outflows.
Ct
NPV =
C0
t
t 1 (1 + k )
n

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Present Value and Rate of Return

A bond that pays some specified amount in

future (without periodic interest) in exchange for

the current price today is called a zero-interest
bond or zero-coupon bond. In such situations,
you would be interested to know what rate of
interest the advertiser is offering. You can use
the concept of present value to find out the rate
of return or yield of these offers.
The rate of return of an investment is called
internal rate of return since it depends
exclusively on the cash flows of the investment.
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Internal Rate of Return

The formula for Internal Rate of Return is

given below. Here, all parameters are given

except r which can be found by trial and
error.
n

NPV =

Ct
C0 0

t
t 1 (1 + r )

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